This article is for investors who would like to improve their understanding of price to earnings ratios (P/E ratios). We’ll show how you can use Fortescue Metals Group Limited’s (ASX:FMG) P/E ratio to inform your assessment of the investment opportunity. Fortescue Metals Group has a price to earnings ratio of 10.39, based on the last twelve months. In other words, at today’s prices, investors are paying A$10.39 for every A$1 in prior year profit.
How Do I Calculate Fortescue Metals Group’s Price To Earnings Ratio?
The formula for P/E is:
Price to Earnings Ratio = Price per Share (in the reporting currency) ÷ Earnings per Share (EPS)
Or for Fortescue Metals Group:
P/E of 10.39 = $2.93 (Note: this is the share price in the reporting currency, namely, USD ) ÷ $0.28 (Based on the year to June 2018.)
Is A High Price-to-Earnings Ratio Good?
A higher P/E ratio means that buyers have to pay a higher price for each A$1 the company has earned over the last year. That isn’t necessarily good or bad, but a high P/E implies relatively high expectations of what a company can achieve in the future.
How Growth Rates Impact P/E Ratios
Probably the most important factor in determining what P/E a company trades on is the earnings growth. That’s because companies that grow earnings per share quickly will rapidly increase the ‘E’ in the equation. That means even if the current P/E is high, it will reduce over time if the share price stays flat. So while a stock may look expensive based on past earnings, it could be cheap based on future earnings.
Fortescue Metals Group shrunk earnings per share by 58% over the last year. But it has grown its earnings per share by 36% per year over the last three years. And over the longer term (5 years) earnings per share have decreased 12% annually. This might lead to muted expectations.
How Does Fortescue Metals Group’s P/E Ratio Compare To Its Peers?
The P/E ratio indicates whether the market has higher or lower expectations of a company. The image below shows that Fortescue Metals Group has a P/E ratio that is roughly in line with the metals and mining industry average (9.8).
That indicates that the market expects Fortescue Metals Group will perform roughly in line with other companies in its industry. If the company has better than average prospects, then the market might be underestimating it. Checking factors such as the tenure of the board and management could help you form your own view on if that will happen.
Don’t Forget: The P/E Does Not Account For Debt or Bank Deposits
It’s important to note that the P/E ratio considers the market capitalization, not the enterprise value. Thus, the metric does not reflect cash or debt held by the company. Theoretically, a business can improve its earnings (and produce a lower P/E in the future), by taking on debt (or spending its remaining cash).
Such spending might be good or bad, overall, but the key point here is that you need to look at debt to understand the P/E ratio in context.
Fortescue Metals Group’s Balance Sheet
Fortescue Metals Group’s net debt is 34% of its market cap. This is enough debt that you’d have to make some adjustments before using the P/E ratio to compare it to a company with net cash.
The Verdict On Fortescue Metals Group’s P/E Ratio
Fortescue Metals Group’s P/E is 10.4 which is below average (15.1) in the AU market. Since it only carries a modest debt load, it’s likely the low expectations implied by the P/E ratio arise from the lack of recent earnings growth.
Investors have an opportunity when market expectations about a stock are wrong. If it is underestimating a company, investors can make money by buying and holding the shares until the market corrects itself. So this free visual report on analyst forecasts could hold they key to an excellent investment decision.
Of course you might be able to find a better stock than Fortescue Metals Group. So you may wish to see this free collection of other companies that have grown earnings strongly.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.